Indicator Insights Part 2: Managing Trades with Parabolic SARTrade management is tough. You’re having to make split second decisions with hard-earned money on the line. There is a great deal of column inches dedicated to trade entry, but consistent and effective trade management is often what makes or breaks a trading account.
In this second instalment of our Indicator Insights series, we’ll turn our attention to the Parabolic SAR (Stop and Reverse) and explain how it can be used as a consistent trade management tool.
We’ll highlight what makes the Parabolic SAR so effective, outline its limitations, and run through several techniques designed to maximise its effectiveness.
Understanding Parabolic SAR
The Parabolic SAR offers dynamic trade management by creating dots above or below the price. Its calculation, involving an Acceleration Factor and Extreme Point, allows for adaptive trailing stop-loss levels that adjust with price movements. We won’t delve into the calculations, but here’s a bit more background on the factors that create the Parabolic SAR.
Acceleration Factor:
Think of the acceleration factor like a speed dial. It starts slow and increases its speed gradually. This 'speed' decides how quickly the dots (trailing stops) move closer to the price when a trend strengthens.
Extreme Point:
The Extreme Point is like a highlighter for the highest high or lowest low seen so far in a trend. It marks that special point, and as the trend progresses, this point changes based on new highs or lows.
Standard Settings:
By default, the Parabolic SAR often starts with an initial AF value of 0.02, which increases by 0.02 each time a new high (or low for downtrends) happens. This increase continues up to a maximum value, commonly set at 0.20. These settings decide how fast the dots move and how close they stay to the price.
Parabolic SAR at Standard Settings
Past performance is not a reliable indicator of future results
Dynamic Stop Management
The Parabolic SAR is a one-stop-shop for dynamic stop placement. It can be used to tell you where to place your initial stop loss, and where to move your stop loss as the trade progresses.
Advantages:
Objective Trade Management
Emotion Mitigation: During live trades, emotions run high. Parabolic SAR offers objective guidance by providing clear stop levels, reducing emotional decision-making during volatile market movements.
Adaptability to Market Volatility
Volatility Adjustment: Parabolic SAR's adaptability to market volatility stands out. Its dynamic nature adjusts stop-loss levels based on market fluctuations, accommodating both rapid and gradual price movements.
Limitations:
Delayed Response and Choppy Markets
Lagging Indicator: Parabolic SAR's reliance on past price data can result in delayed responses to recent price changes, making it a lagging indicator.
Choppy Market Performance: In choppy or sideways markets, where price movements lack a clear trend, Parabolic SAR can generate false signals, leading to ineffective trade management strategies.
Managing Trades Using Parabolic SAR
To effectively use Parabolic SAR as a trade management tool, it is essential that the indictor compliments your trade entry method.
Remember, the Parabolic SAR has a time lag and performs best in trending markets, hence it favours a momentum-based entry method such has entering on a breakout from a consolidation pattern in the direction of the dominant trend.
However, there is an advanced technique which allows you to use the Parabolic SAR to manage reversal trades by dropping down to a lower timeframe. Let’s look at both techniques in more detail…
Basic Technique: Single Timeframe
The most straightforward method is to use the Parabolic SAR on the same timeframe as your entry.
Your initial stop is placed at the location of the Parabolic SAR dot above/below your entry candle. Your stop is then trailed to every new dot that appears – locking in profits as the trend progresses. The trade is closed when your stop is hit or when the dots switch sides.
Worked Example: Range Breakout
In this example we have a range breakout in-line with the dominant trend. The Parabolic SAR can is used for initial stop placement and as a dynamic trailing stop loss. Notice how the stop loss is tightened more aggressively as the trend starts to lose momentum – this is a key advantage to using the Parabolic SAR.
S&P 500 Daily Candle Chart
Past performance is not a reliable indicator of future results
Advanced Technique: Dual Timeframe
A more advanced method allows you to utilise Parabolic SAR’s consistent and dynamic trailing stops when managing counter-momentum reversal trades. It involves using the Parabolic SAR on a lower timeframe with a view to ‘swinging’ in and out of lower timeframe trades in the direction of the higher timeframe trade setup.
This method has the advantage of offering potentially higher levels of risk / reward, but it requires a higher degree of skill and experience as traders must be considerably more active when managing the trade.
Worked Example: Daily Fakeout, Hourly Trade Management
In this example, a fakeout pattern forms at a clear level of support on the daily candle chart:
Nvidia (NVDA) Higher Timeframe: Daily Candle Chart
Past performance is not a reliable indicator of future results
The trade can be actively managed using the Parabolic SAR on the hourly candle chart. Notice the potential for re-entering the trade – the Parabolic SAR can be used to take momentum-based lower timeframe trades that align with a higher timeframe catalyst.
Nvidia (NVDA) Lower Timeframe: Hourly Candle Chart
Past performance is not a reliable indicator of future results
Summary:
The Parabolic SAR helps to remove the stress from trade management. It provides traders with an objective and consistent rule set that dynamically adjusts to the volatility of the market. The Parabolic SAR compliments momentum-based trading strategies and can help to manage risk as a trade progresses. It can also be used on a lower timeframe to compliment counter-momentum trades on a higher timeframe.
Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance. Social media channels are not relevant for UK residents.
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